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Jewish World Review Oct. 1, 1999 /21 Tishrei, 5760

Lawrence Kudlow

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What's really bugging
the stock market? -- A LOT OF PEOPLE are talking about a lot of issues. Some have merit, others don't. Tight money is a problem. So is the tax cut veto. So is the Justice Department's attack on the tobacco industry. And the Microsoft anti-trust actions.

But the dollar is steady, not weak. What's more, I wish everyone could have trade deficits. In our era of hi-tech price stability, trade deficits infer prosperity. So let's try to sort all this out. Eventually, it's going to have a happy ending.

We know this year's stock market has been heavily burdened by Fed tightening and the constant threat of more to come. Everyone's been talking about this; indeed obsessing over it.

Alan Greenspan's first tightening signal in early May effectively stopped a huge winter/spring rally. The market recovered after that, but Greenspan's Congressional testimonies in July knocked down the Dow by about 600 points. Not just the threat of more light taps on the monetary brake, but his public anti-growth and anti-stock market message has tied a ball and chain around the market's ankles.

Ironically, the alleged market bubble has already been punctured. The major stock market indexes are going through one of their periodic rolling corrections. Like the autumn of 1998, or the summer of 1997, or the Fed tightening period in 1994.

These are healthy cleansings. Not bear markets, but corrections. Rolling "asset bubble" punctures. It's an Internet economy thing. Fed or no Fed, self-regulating private markets know when to cleanse over-valued shares. We don't really need Steve Ballmer's help.

During long-wave Schumpeterian technology cycles, the economy, productivity, real wages, real incomes and the stock market all grow above trend. Inflation and interest rates come in below historical norms. Recessions and bear markets come and go, but they are muted. Like the 1990 bear market recession: relatively shallow and short-lived.

So, the big bear is muted; replaced by a recurring series of little bears. All very healthy, especially if you believe in family values.

Take this year's little bears. More than half of the S&P 500 stocks are down year-to-date, and more than one-quarter of the listed New York Stock Exchange and NASDAQ companies are well below their yearly highs. Internets have been slaughtered. Greenspan should be very happy.

But there's more right now than Alan Greenspan and the Fed sopranos. For example, one thing nobody's talking about is the stock market impact of President Clinton's tax-cut veto.

When Congress passed a broad-based pro-investor tax cut bill in late July and early August, the Dow moved from 10,600 to nearly 11,400. Supply-siders estimated that inflation-indexed capital gains, estate tax elimination, expanded IRAs, an end to the alternative minimum tax, health insurance deductions and income tax-rate relief would add as much as one-half of one percentage point to the long term economic growth rate, with derivative benefits for risk-taking, capital formation, productivity and profits.

And long-term wealth creation that would be capitalized into higher share prices. But after President Clinton returned from New Zealand in early September, with the Dow above 11,000, and he proceeded to totally trash the tax-cut proposal (after Greenspan had trashed the stock market two weeks earlier), the market headed down. It hasn't stopped yet.

Not only is the President relying on the usual liberal-left class warfare argument ("too much relief for the wealthy"), he wants to keep the money for all his pet spending programs ("it would leave too little money for important programs"). Remember, the President's budget includes roughly $150 billion in additional social spending, with a Medicare and free drug prescription entitlement plan that would sum to nearly $1 trillion over the next decade.

So the first big test in the era of surplus politics produces a government victory and a free enterprise defeat. Tax rates will not be cut, and government will expand.

The surplus revenues will not be returned to the people who earned them in the first place. Of course the stock market would react negatively to this, even if most economists and pundits and television announcers don't get it.

More goofiness from Washington comes in the form of the Justice Department's RICO-based lawsuit against the tobacco industry. This is a blatant abrogation of corporate private property rights. The stock market hates it.

It is political retribution from the Clinton administration because their Federal tobacco tax hike was defeated. Of course they want to extract another pound of flesh from tobacco, even after the state lawsuits, in order to grab more revenues and expand spending.

Then, too, Assistant Attorney-General Joel Klein has been out bashing Microsoft as the Federal court hearings have finally come to an end. News stories report that Mr. Klein and his merry band of anti-trust anti-growth re-regulators have been traveling around the world trying to persuade foreign governments to sue Microsoft. This too sends a chill through all technology stocks.

Next year the Investor Class will vote its portfolios in favor of lower taxes, deregulation and market solutions; that is why Gov. George W. Bush is running way ahead of Al Gore and Bill Bradley. But in the meantime, stock markets are registering their disapproval of the tax veto and the heavy-handed government attacks on business.

I believe the Republicans in Congress are giving up too easily on taxes. This is a tax bill where the sum of the individual parts is greater than the whole. Each part should be voted on; let Messrs. Clinton and Gore veto every pro-investor tax cut plan, if they dare. The GOP ought to run national ads touting the individual parts and linking to the Internet economy by speaking directly to the Investor Class.

As for King Dollar, it is still sitting on its throne. The dollar futures index is only 4.5% off its high, and while hovering around 100 is 25% above its 1995 low. Using the JP Morgan index the results are about the same. Against the Euro, the dollar is very strong. Relative to Canada and Mexico, our two biggest trading partners, the dollar is strong.

The Japanese yen is overshooting on the upside, but this is a high-class problem. Following last spring's supply-side tax cuts, higher expected economic returns in Japan are boosting the real yen exchange rate and the stock market. Anticipating a healthier Japan, foreign capital inflows are re-liquefying their economy and boosting asset values.

But the dollar decline relative to the yen is not spreading to the other major currencies. So itís an overly strong yen, not a weak dollar. In relation to gold, precious metals and non-oil commodity indexes, the dollar remains strong and U.S. inflation remains low. Long-term Treasury rates have peaked. This is a good story.

Finally, recent hysteria over the U.S. trade deficit is completely unwarranted. Bearish economic banshees are on the loose again, arguing that trade deficits will weaken the dollar and drive up interest rates. This of course will collapse the stock market and force the economy off the recessionary cliff.

And then perpetually pessimistic Keynesian demand-siders will finally be proven right after all. Aha, I told you so. Prosperity is doomed.

Not so fast fellas. Consider this. The U.S. trade position has been in deficit for nearly twenty consecutive years. But the economic results have been splendid. Since mid-1982, when the trade deficit trend began, the U.S. economy has produced 38.3 million new jobs with a real GDP growth rate of 3.3% per year.

Corporate profits have expanded by 9.4% annually, while the S&P 500 index (adjusted for inflation) has increased 11.9% yearly, with a total return rate of 16% a year. Unemployment has fallen to nearly 4%, while inflation is nil. Roughly $26 trillion in new household net worth has been created.

All this while the big, bad, evil trade deficit continues. Imagine that. In 1982, real U.S. two-way trade -- exports and imports -- totaled $738 billion. Today the number is $1.6 trillion. Real exports over the past seventeen years have increased 81%, or 3.5% per year. Real imports have been even stronger, rising 128%, or 5% annually.

Imports have grown faster than exports because the U.S. economy has consistently grown faster than the rest of the world. Increasingly we are importing low value goods and exporting high value goods. Interest rates zig and zag, but on balance the trend has been substantially lower during the trade deficit era. Ditto for inflation. Meanwhile, the dollar has also had its ups and downs, but on balance its value against a large basket of currencies has been relatively stable. In relation to domestic gold and commodity prices, the dollar gets stronger and stronger.

With this enhanced buying power, American consumers now have the online Internet capability to search for and identify the highest quality goods at the lowest available prices anywhere in the world. Because we have the lowest average tariff rates of any major country, these goods and services can be cheaply and easily imported. Families and businesses prosper as never before. Free trade is more important than trade deficits.

The key point is that the rising combined total of imports and exports shows what a healthy economy we have. The fact that imports have been rising faster than exports is of no economic consequence. Actually, exports are badly undercounted anyway. Small businesses don't fill out the requisite forms, and software and related technology and communications exports are not identified by the government.

In fact, the whole trade balance model that upsets Keynesian economists so much is a quaint leftover from the 1950s, when the flow of goods from steel, autos, heavy machinery and raw materials dominated world trade flows. However, in today's nano-second Internet economy, where financial markets rule the world, capital flows drive trade.

Over the past seventeen years, foreign capital inflows for portfolio investment purposes (stocks and bonds) have increased by 19.3% at an average annual rate. Inflows for direct investment in plant, equipment, mergers and acquisitions have increased at a 15% annual rate. In total, net foreign capital inflows have grown by an incredible $4.8 trillion.

The key point here is that foreign capital comes in search of a high rate of return on investment. America's technology economy, backed by disinflation, deregulation and low capital tax-rates, has consistently produced the best investment returns in the world. That is why foreign capital comes here. Foreigners are investing wisely.

No one holds a gun to their heads. Foreign capital arrives voluntarily. Even our Army, Navy and Air Force couldn't keep this foreign capital away. But repeated liquidity injections from foreign capital inflows have made our economy even stronger, allowing investment to rise even more. And since we produce to consume -- remember Say's Law of Markets -- high domestic returns coupled with sizable foreign capital inflows leads to even more growth and, yes, more imports.

Want to end trade deficits? Radically raise interest rates, or tax rates, or tariff rates, or impose Nixonian wage and price controls. This will produce a recession, or worse. So no one will import. Or do anything else commercially. And the Keynesian trade balance crowd will be thrilled.

Of course, the five or ten million unemployed workers suffering the consequences of these anti-growth policies might be forgiven if they scream bloody murder and vote out the nitwits who launched these policies in the name of trade balance. The 100 million plus Investor Class might also be a little miffed while their portfolio wealth implodes. All this to pursue the stale ideas of a bunch of defunct economists?

It may not be arithmetically possible in our medieval economic world of national income accounts and balance of payment identities, where trade deficits must eventually balance with trade surpluses, but in my heart of hearts I wish that all nations could prosper to the point where they run large trade deficits. It would be a sign of strong global growth.

Maybe we could set up a new trade account on the moon. It would perpetually be scored as a notional trade surplus. Then the bean counters would be happy, and the earth would be prosperous. Trade deficits everywhere.

I can understand market worries over taxes, tobacco and Microsoft. But I don't for one minute believe that we are headed into an era of heavy government regulation. The Investor Class will prevent that. Watch next year's elections.

But I think people should recognize, or at least consider the analytical possibility, that a strong dollar and wide trade gaps are consistent with long-term economic growth and price stability. Employment, incomes and profits are rising. The fundamentals of this economy remain solid; that is the most important bottom line point. The Internet economy is more important than the Fed.

Stock market corrections come and go, but the long wave of prosperity remains intact. My liberterian friend Jim Glassman has just written a book predicting a 36,000 Dow. My supply-side friend Chuck Kadlec has just written a book predicting a 100,000 Dow.

In "American Abundance", which was published nearly two years ago, I predicted an over 50,000 Dow. Naturally, we all like to hang out with our friends. I believe my friends and I will be proven right.

This little bear correction will end before too long. Then there will be stock market bargains galore. Stay invested. Stay optimistic. Keep the faith. Faith is always the spirit.

JWR contributor Lawrence Kudlow is chief economist for Schroder & Co. Inc and CNBC. He is the author of American Abundance: The New Economic & Moral Prosperity. Send your comments about his column by clicking here.


09/23/99:Growth Trade
09/09/99: Bad Dollar Logic
09/09/99: Buttered bread
08/31/99: Bull Market Alive and Well
08/26/99: Let Prices Rule
08/19/99: Blame OPEC, Not Growth

©1999, Lawrence Kudlow